Changing Tides - stock option taxation - Statistical Data Included

California CPA, July, 2001 by Karen Goodfriend, GARY McBRIDE

Real Taxes on Virtual Income: The ISO Dilemma

UP AND DOWN. UP AND DOWN.

The last few years have been a roller coaster for employees who have held stock options, especially those in California's technology sector. While some have accumulated significant wealth, others have watched potential fortunes evaporate. Stock options' volatility introduces complexity when providing tax and financial planning services. Without a crytal ball to predict future stock prices, it is challenging to know the best timing for option exercise and stock sale. However, it is possible to counsel clients on strategies to help them achieve their goals and minimize risk.

Last year demonstrated how profoundly stock prices can affect strategies for dealing with incentive stock options. At the beginning of 2000, technology industry employees with stock options were optimistic about their companies and future stock prices. By year-end. every other Internet stock was worth less than $5 and one of every five was literally a penny a stock. according to Pegasus Research International. Thus, employees' optimism about the stock price proved unfounded for most Internet and many established technology companies.

The result is a tax problem that is magnified by (but not unique to) California's high-tech firms. A recent letter to Maryland Congressman Wayne T. Gilchrest, from an outraged constituent, "Mary," illustrates the alternative minimum tax conundrum that shocks unsuspecting taxpayers:

I was granted incentive stock options which I exercised (and held) throughout 2000. ... the price for these shares ranged from a high of $43.17 Jan. 4 to a low of about $5 by the end of 2000. They are now practically worthless. This strange and unfair law has resulted in a total tax liability of $112,000 for the year 2000. That is, $40,000 in regular income taxes on real income I actually earned, and another $72,000 in AMT that is on income I never actually received, and income I may never actually receive given the stock price. Thus, I find myself having to scramble to coma up with $65,000 in cash to cover the additional ANT.

In retrospect, it is easy to see that Mary would have profited if she had sold the stock at its peak, immediately after exercising the ISOs. Alternatively, she would have avoided the loss of most of her exercise price and all of the AMT tax debt if she had simply never exercised the options. Unfortunately, the tax law motivated Mary to shun both of these strategies. If she sold her ISO stock within one year of exercise, she would sacrifice the 20 percent long-term capital gain tax rate. If she anticipated continued stock appreciation, then she would increase her AMT gain by delaying exercise. AMT gain is equal to the spread (stock FMV minus ISO exercise price) on the date of exercise. The tax law encourages taxpayers to exercise early and hold the shares for at least one year. When a stock tanks, that tax smart strategy compounds the taxpayer's problems.

DEALING WITH AMT

To preserve capital gain treatment on stock disposition, and avoid compensation income on the spread (FMV minus strike price), ISO stock must be disposed of no earlier than two years from when the option is granted, and one year from exercise (IRC Sec. 422). For individuals who do not hold their stock for the requisite holding periods, the transaction is considered a "disqualifying disposition" and the lower of the bargain element on date of exercise or the gain on sale is treated as compensation income. There is no AMT gain if the stock is sold in the year of exercise.

A possible solution for Mary is to recoup the ANT. However, this depends on the relationship between regular taxable income and ANT income. All or most of the AMT from a stock option exercise is creditable in subsequent years to the extent that the regular tax exceeds the tentative minimum tax, although the excess may never materialize.

Mary's AMT basis matches the high FMV on the exercise date and if she sells the stock for peanuts in 2001, the transaction will produce minimal if any regular tax (low basis, low sales price) and a large AMT capital loss (high basis, low sales price). The ANT capital loss is limited to $3,000 per year (assuming no other ANT capital gains), limiting the excess of the regular tax over the tentative minimum tax. The AMT loss and AMT credit can be carried over to subsequent years, subject to the same limitation.

Potentially, the employee may be pushed into bankruptcy or insolvency as a result of the exercise-year tax liability. In recognition of the frequency of high-tech employee insolvency, the Franchise Tax Board has established a special team to deal with ISO ANT-related offers in compromise.

How can we help our clients avoid this type of disaster? The adviser has the most opportunity to influence the outcome in the year the option is exercised. Even if the tax year has closed, there are still planning approaches available for clients in these predicaments.

PRE-EXERCISE STRATEGIES

Before a client exercises ISOs, numerous approaches should be contemplated: